Those Who Forget History, Are Probably Historians

There are hardly any economists or economic historians who have contributed more to our understanding of the role of international finance in the Great Depression than Barry Eichengreen and Peter Temin. [1] So it’s disappointing to see them so strenuously refusing to learn from that history.

They start by correctly observing that the fatal flaw of the gold standard was the “asymmetry between countries with balance-of-payments deficits and surpluses. There was a penalty for running out of reserves .. but no penalty for accumulating gold.” Thus the structural tendency toward deflation in the gold standard era, and the instability of the system once workers recognized that lower wages for “sound money” wasn’t such a great deal. If Temin and Eichengreen want to draw a parallel with the Euro system today, well, I’m not sure I agree, but it’s an avenue worth pursuing. But as they want to apply it, to the US and China, it’s unambiguously wrong, as economics and as history.

“The point,” say Temin and Eichengreen, “is not to let deficit countries off the hook.” Barry, Peter — read your books! Letting the deficit countries off the hook is exactly the point. If there’s one lesson in Lessons from the Great Depression, it’s that no practical response to the crisis was possible until the idea that a trade deficit represented a kind of moral failing was abandoned. The whole point, first, of leaving the gold standard, and later, of the Bretton Woods institutions, was to free deficit countries from the obligation to “live within their means” by curtailing domestic investment and consumption.

Keynes couldn’t have been clearer on this. The goal of postwar monetary reform, he wrote, was “A system which would maintain balance of payments equilibrium without trade discrimination but also without forcing unemployment .. on deficit countries,” [2] in other words, a system in which governments’ efforts to pursue full employment was not constrained by the balance of payments. We needn’t take Keynes as holy writ, but if we’re going to analyze current arrangements in light of his writings in the 1940s, as Temin and Eichengreen claim to, we have to be clear about what he was aiming for.

One would expect, then, that they would go on to show how “global imbalances” are constraining national efforts to pursue full employment. But they don’t even try. Instead, they offer ambiguous phrases whose vagueness is a sign, perhaps, of a bad conscience: Keynes “wanted measures to deal with chronic surplus countries.” What kind of surpluses, exactly? and deal with how?

The beginning of wisdom here is the to recognize the distinction between the balance of payments and the current account. Keynes was concerned with the former, not the latter. Keynes didn’t care if some countries ran trade surpluses or deficits, temporarily or persistently; what he cared about was that these imbalances did not interfere with other countries’ freedom “to pursue full employment and progressive social policies.” In other words, current account imbalances were not a problem as long as the financial flows to finance them were guaranteed.

“Creditor adjustment” is rightly stressed by Eichengreen and Temin as a central feature of Keynes’ vision of postwar monetary arrangements, but they seem to have forgotten what it meant. It didn’t mean no one could run a trade surplus, it just meant that the surplus countries would be obliged to lend to the deficit ones as much as it took to finance the trade imbalances. As Keynes’ follower Roy Harrod put it,”The most important requirement [is] to get the United States committed to creditor adjustment. …. Creditor adjustment could be secured most simply by an agreement that the creditor would always accept cheques from the deficit countries in full discharge of their debts. … So long as their credit position cannot cause pressure elsewhere, there is no harm in allowing a further accumulation.” All of Keynes’ proposals at Bretton Woods were oriented toward committing the countries with surpluses to lend, at concessionary rates if necessary, to the deficit ones.

China today accepts American checks in full discharge of our debts; they don’t demand payment in gold. The Chinese surplus isn’t putting upward pressure on US interest rates, or constraining public spending. All Keynes ever wanted was for all surplus countries to be like China.

“Sixty-plus years later, we seem to have forgotten Keynes’ point,” Eichengreen and Temin conclude. True that.

[1] The strangely forgotten Robert Triffin is one.

[2] The historical material in this post post, including all quotes, is drawn from chapters 6 and 9 of the third volume of Robert Skidelsky’s biography of Keynes.

What is Keynesianism?

[A bit of thumbsucking inspired by discussion here.]

As a policy of countercyclical demand management, Keynesianism is based on the idea that there are no automatic forces in industrial capitalism that reliably equilibrate aggregate supply and aggregate demand. In the absence of government stabilization policies, the economy will waver between inflationary periods of excess demand and depressed periods of inadequate demand. The main explanation for this instability is that private investment depends on long-term profitability expectations, but since aspects of the future relevant to profitability are fundamentally uncertain [1], these expectations are unanchored and conventional, inevitably subject to large collective shifts independent of current “fundamentals”. Government spending can stabilize demand if G+I varies less over the business cycle than I alone does. For which it’s sufficient that government spending be large. It’s even better if G and I move in opposite directions, but the reason Minsky answered No to Can “It” Happen Again? was because of big government as such, not countercyclical fiscal policy.The focus on cyclical stabilization assumes that there is no systematic long-term divergence between aggregate supply and aggregate demand. But Keynes believed that there was a secular tendency toward stagnation in advanced capitalist economies, so that maintaining full employment meant not just using public expenditure to stabilize private investment demand, but to incrementally replace it. Another way of looking at this is that the steady shift from small-scale to industrial production implies a growing weight of illiquid assets in the form of fixed capital. [2] There is not, however, any corresponding long-term increase in the demand of illiquid liabilities. If anything, the sociological patterns of capitalism point the other way, as industrial dynasties whose social existence was linked to particular enterprises have been steadily replaced by rentiers. [3] The whole line of financial innovations from the first joint-stock companies to the recent securitization boom have been attempts to bridge this gap. But this requires ever-deepening financialization, with all the social waste and instability that implies. It’s the government’s ability to issue liabilities backed by the whole economic output that makes it uniquely able to satisfy the demands of wealth-holders for liquid assets. In the functional finance tradition going back to Lerner, modern states do not possess a budget constraint in the same way households or firms do. Public borrowing has nothing to do with “funding” spending, it’s all about how much government debt the authorities want the banking system to hold. If the demand for safe, liquid assets rises secularly over time, so should government borrowing.From this point of view, one important source of the recent financial crisis was the surpluses of the 1990s, and insufficient borrowing by the US government in general. By restricting the supply of Treasuries, this excessive fiscal restraint spurred the creation of private sector substitutes purporting to offer similar liquidity properties, in the form of various asset-backed securities. (Here is a respectable mainstream guy making essentially this argument. [4]) But these new financial assets remained at bottom claims on specific illiquid real assets and their liquidity remained vulnerable to shifts in (expectations of) the value of those assets. The response to the crisis in 2008 then consists of the Fed retroactively correcting the undersupply of government liabilities by engaging in a wholesale swap of public for private liabilities, leaving banks (and liquidity-demanding wealth owners) holding government liabilities instead of private financial assets. The increase in public debt wasn’t an unfortunate side-effect of the solution to the financial crisis, it was the solution. Along the same lines, I sometimes wonder how much the huge proportion of government debt on bank balance sheets — 75 percent of assets in 1945 vs. 1.5 percent in 2005)contributed to the financial stability of the immediate postwar era. With that many safe assets sloshing around, it didn’t take financial engineering or speculative bubbles to convince banks to hold claims on fixed capital and housing. But as the supply of government debt has dwindled the inducements to hold other assets have had to grow increasingly garish. From which I conclude that ever-increasing government deficits may in fact be better Keynesianism – theoretically, historically and pragmatically – than countercyclical demand management.
[1] Davidson, Shackle, etc. would say nonergodic. This strand of Post Keynesian thinking often wanders beyond my comfort zone.[2] This shift is ongoing, not just historical — not only do capital-output ratios continue to rise in manufacturing, but we’re seeing the “industrialization” of retail, health care, etc.

[3] Schumpeter is the only major economist to give sufficient attention to the sociology of the capitalist class, IMO. Marx’s insistence that the capitalist is simply the human representative of capital is a powerful analytic tool for many purposes, but it leaves some important questions unasked.

[4] Here is another.